Tuesday, December 02, 2008

My Fantasy

As a postscript to my lasttwo blog entries, I want to imagine a possibility.

Suppose that the Treasury were to retire all its outstanding long-term debt, and suppose that the Fed were to buy enough of its short-term debt to keep the interest rate at zero. And suppose this were all done without causing inflation. I realize, for institutional reasons, this is all highly unlikely to happen, and it is also somewhat unlikely for economic reasons. But it isn’t inconceivable. In fact, leaving aside the institutional issues, I’d give maybe a 25% chance that it’s economically possible today, provided that the fiscal stimulus is not large enough (which is likely to be true in any case). You can disagree, but anyhow, this is only a fantasy, and I’m pretty sure I can get quite a few reputable economists to agree that my suppositions are far from inconceivable, economically speaking.

79 Comments:

>> Anyhow, I don't know how you can say "there are just too many historical data points" when the latest data point from a nation comparable in advancement to US goes the other way.

Well, no. Japan is very different. They, effectively, self-funded their prolifigacy. They took money from their left pocket and deposited it their right pocket. By contrast, the US is taking money from everyone else's pocket and spending it at the racetrack.

I don't know of a single example of a fiat currency issuer that has racked up immense external debt that hasn't seen its currency go to zero. Z-e-r-o.

Or, to get back to your post here: if the US can (theoretically or otherwise) use the printing press to pay off its debts, why doesn't eveyone do that? Why doesn't Peru do that? Or Argentina? Or the Ukraine? Hey, why doesn't Russia do that now? Instead of plowing through their reserves, why not just print the money and retire the debt?

The standard answer here is that the US issues the world's reserve currency and that is supposed to make all the difference. But this is simply a convention. Fashions change.

Peru, Russia, etc. can't pay off their debts with fiat money because their debts are largely denominated in foreign currencies. And whether or not the dollar remains "the world's reserve currency," it will almost certainly remain one of the 4 or 5 major currencies (actually one of the 3), which makes it, if not "the" reserve currency, at least "a" reserve currency.

I don't know of a single example of a fiat currency issuer that has racked up immense external debt that hasn't seen its currency go to zero.

Britain in the 19th century IIRC.

I don't think you can cite any (other) example of a major world economic power that took on a large external debt. So if I'm correct about Britain, the score is 1 to 0 in favor of the hypothesis that a major world power can take on a large external debt without subsequently experiencing severe inflation.

Note, however, that inflation is not the same thing as having a weak currency. I'm not denying that the dollar is likely to weaken over time relative to other currencies. But that will have only a modest effect on the domestic inflation rate. Unless it happens precipitously, in which case it will have a fairly dramatic effect for a year or so, which will die out over the following year.

Also note that the potential for deflation right now is not a problem affecting exclusively the US. If the US follows an extreme easy money policy, Europe and Japan, if they have any sense, will follow suit. (Europe in particular has limitations on fiscal policy that may be a problem and may induce them to use monetary policy more aggressively.) Now you can say that the whole world will experience severe inflation, but I doubt it.

For the past 25 years, we've repeatedly heard people say that inflation was going to get out of control, because some monetary aggregate was growing too fast (which implies that base money is growing too fast, given the relevant multiplier) or whatever. They've been wrong every time. There is no real measure of how fast is too fast. You can keep coming back and saying, "Oh well, last time wasn't really all that fast, but this time is ridiculous." At what point should we start believing you?

The right answer here is because nobody would buy the debt. And why would no one buy the debt? Because the issuers have a habit about printing money willy-nilly to get themselves out of tight economic corners.

So: how is the US fundamentally different? If what were happening to the US were happening to a Peru or an Argentina, what would be happening to the Sole or the Peso? We need not speculate -- just look at Iceland and its Kroner.

>> I don't think you can cite any (other) example of a major world economic power that took on a large external debt.

Plenty of other countries take on large external debt (relative to GDP) and all their currencies go poof. Throw a dart at South America.

>> Now you can say that the whole world will experience severe inflation, but I doubt it.

This is precisely what I am saying.

>> At what point should we start believing you?

Who wudda thunk the Fed's balance sheet would have ballooned into the trillions in a matter of *months*.

The right answer here is because nobody would buy the debt. And why would no one buy the debt? Because the issuers have a habit about printing money willy-nilly to get themselves out of tight economic corners.

So: how is the US fundamentally different? If what were happening to the US were happening to a Peru or an Argentina, what would be happening to the Sole or the Peso? We need not speculate -- just look at Iceland and its Kroner.

But this isn't happening to the dollar, despite the dramatic growth of the monetary base. People just can't get enough dollars. I'm not sure what you're saying: it always happens; but it's not happening in this case. That's called a counterexample. Instead of accepting the counterexample, you argue that it will happen in the future. But if it's not happening now, the old pattern is already broken. The US is still able to borrow in its own currency, and on quite favorable terms. It's not a pattern that you've seen anywhere else, so how can you draw conclusions based on what happened elsewhere?

>> Now you can say that the whole world will experience severe inflation...

This is precisely what I am saying.

You're going to have to make up your mind whether you're talking about the dollar as foreign exchange or just about the value in terms of goods. If the inflation is world-wide, the question of the US external debt is pretty much irrelevant.

>> Throw a dart at South America, and you will be sure not to hit a major world economic power. So again, 0-0.

I never said "world economic power". (You inserted that bit.) Rather, I said any "fiat currency issuer with large external debt" has seen its currency go poof. And that much is true.

One of the problems here is that fiat currency is a very new development (40 years), so one's sample size is very small. But, fwiw, the Rouble was massively devalued after the fall of the Soviet Union and certainly the Soviet Union qualifies as a "major power." And the Pound Sterling would have lost the bulk of its value against the dollar since it morphed into a fiat currency and this while the dollar has lost most of its value against real things since it did the same.

Again, the sample size for "major economic powers" is so small, but it remains that the combination of massive external debt and fiat currencies almost always results in the end of the fiat currency. I believe the onus would be on you to say how being a "major economic power" immunizes you from these economic forces.

>> But this isn't happening to the dollar, despite the dramatic growth of the monetary base. People just can't get enough dollars.

There is certainly a dollar squeeze on now but I would say this is the result of the de-leveraging process. What happens when this is complete?

>> You're going to have to make up your mind whether you're talking about the dollar as foreign exchange or just about the value in terms of goods.

One of the problems here is that fiat currency is a very new development (40 years), so one's sample size is very small.

What I should have said is that a world where only fiat currencies operated is very new. There have been fiat currencies throughout history (all went poof), but it was only when Nixon closed the gold window in the early 70's did we see a world where there were no "hard" currencies. Certainly, prior to the early 70's, all "major economic powers" issued hard currency. So in this regard, the sample size for "major economic powers" issuing fiat currency is quite small.

Well, I will think about all this, but one point that comes to mind is that "hard currencies" are not really all that hard. They essentially constitute a randomly managed money supply. You could have plenty of inflation when there were major new gold discoveries. Or when people found something they liked better than gold. And of course you could have plenty of deflation when people developed an excessive fondness for gold (which was roughly equivalent to the excessive fondness they have for T-bills today).

Gold doesn't have a whole lot of intrinsic value. Granted it has more intrinsic value than fiat money (which is to say, it has some intrinsic value), but mostly people have wanted gold because it was valuable, and it was valuable because people wanted it -- the same circular logic that gives fiat money its value.

The great advantage of fiat money is that when people develop an excessive fondness for it, the monetary authority can (in principle, at least) satisfy their desire and avoid deflation. And similarly, when people lose their fondness for money, the monetary authority can take it away and avoid inflation. (Granted, the Fed was a little late on the draw during the 1970's, but it did manage to stop inflation. In recent cycles, it has been quicker, and I don't see any reason why it wouldn't make decent time in the current cycle -- although it may deliberately allow some inflation to provide a bulwark against deflation.)

Also, modern hard currencies, when they existed, weren't really hard at all, because they could be devalued. But I think I'm getting away from the point now, so I'll sign off until tomorrow, at least.

[Hard currencies] essentially constitute a randomly managed money supply. You could have plenty of inflation when there were major new gold discoveries.

Fluctuations in new supply of gold are infinitesimal as compared to existing monetary stocks. Moreover, increases in supply tend to be correlated with advances in technology/productivity, which generally calls for increases in money supply anyway.

Or when people found something they liked better than gold.

Like?

Gold doesn't have a whole lot of intrinsic value.

Then how come it has been coveted for 5000 years? The same can hardly be said of fiat money.

Sorry to interrupt the debate, but couldn't help pointing out what Bernanke once said.

"The general argument that the monetary authorities can increase aggregate demand and prices, even if the nominal interest rate is zero, is as follows: Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero. This is an elementary argument, but, as we will see, it is quite corrosive of claims of monetary impotence."(http://www.princeton.edu/svensson/und/522/Readings/Bernanke.pdf)

This logic is kind of famous in Japan, known as "Bernanke's reductio ad absurdum."

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